Investment

In ordinary sense, investment means to purchase shares, bonds and various types of capital
assets. But the purchase of old shares, bonds and capital assets is not the real investment. Such
investment is called financial investment which does not increase output, employment and
income in the economy. Financial investment merely represents the change in the ownership of
assets. In economic sense, investment means real investment which increases output,
employment and income in the economy. Real investment refers to the expenditure incurred
on the creation of new capital stock such as expenditure incurred on the construction of new
factory buildings, roads, bridges and other forms of productive capital assets, the purchase of
new machinery and equipment etc. Such investment results in the increase in output,
employment and income in the economy. Keynes and many other economists have included
the increase in inventories of goods in investment.

Investment Function

Investment function shows the functional relationship between investment and its
determinants. According to classical economists, investment is a negative function of the rate
of interest. This means that when the rate of interest falls, investment increases and vice versa.
This can be expressed as follows.
I = f (i), f’ (i) < 0
Where,
I = Volume of investment.
f = Functional relationship.
i = Rate of interest.
According to Keynes, volume of investment depends upon the factors stated below.
a. Marginal efficiency of capital (r).
b. Rate of interest (i).
Marginal efficiency of capital (MEC) can be defined as the rate of return expected from an
additional unit of capital asset. Volume of investment increases as MEC increases and vice
versa. There will be no investment if MEC is very low.
Other things remaining the same, fall in the rate of interest encourages investment and rise in
the rate of interest discourages it.
Volume of investment (I) as a function of MEC (r) and rate of interest (i) can be expressed as
follows.
I = f (r, i)
If the rate of interest is constant, volume of investment increases with the rise in MEC and vice
versa. Similarly, if MEC is constant, volume of investment increases with the fall in the rate of
interest and vice versa. These facts can be expressed as follows.
I = f (r, i), f’ (r) > 0
I = f (r̅ , i), f’ (i) < 0
Where,
I = Volume of investment.
f = Functional relationship.
r = Marginal efficiency of capital.
i = Constant rate of interest.
r̅ = Constant marginal efficiency of capital.
i = Rate of interest.

Types of Investment

The main types of investment are as follows.

1. Autonomous and induced investment: Autonomous investment is independent of the
level of income. It is not guided by profit motive. In other word, such investment is
income-inelastic. It does not vary with the level of income, i.e., it remains the same
whatever the level of income may be. Such investment is generally made by the
government to create economic and social infrastructures like roads, dams, canals,
power-houses, school buildings, hospital buildings etc. Private sector may also
undertake such investment. Autonomous investment is influenced by growth of
population, research and innovation etc. Autonomous investment can be illustrated by
the following figure.
 In the above figure, IIa is the autonomous investment curve which is horizontal
straight line. Horizontal straight line autonomous investment curve IIa indicates that
autonomous investment remains constant at any level of income.
Induced investment refers to that investment which changes with the change in the
level of income. Such investment varies directly with the level of income. It increases with
the increase in the level of income and vice versa. Hence, induced investment is the positive
function of the level of income. It is guided by profit motive. It is influenced by the factors
that affect profit such as price, demand, wage rate, interest rate etc. Such investment is
generally made by the private sector. Induced investment can be illustrated by the following
figure.

In the above figure, II is the induced investment curve which is upward sloping. The upward
sloping induced investment curve II indicates that induced investment increases as income
increases and vice versa.
2. Planned (or intended), unplanned (or unintended) and actual investment: Planned
investment refers to that investment which is made intentionally in order to achieve
pre-determined goals. Such investment is made by both government and private
sectors. If the investment is made due to unexpected changes in economic and other
factors, it is called unplanned investment.
Actually realized investment is known as actual investment. It is the sum of
planned and unplanned investment.
3. Gross investment and net investment: Gross investment means aggregate investment.
It refers to the total expenditure incurred on the capital assets in a given period of time.
Gross investment is the sum of net investment and depreciation. Net investment, on the
 other hand, is gross investment minus depreciation. According to Keynes, real
investment refers to net investment.
4. Public and private investment: The investment made by the government is called public
investment. Public investment is not guided by profit motive. Such investment is made
for social welfare and not for profit. Public investment includes the expenditures
incurred by the government on the construction of roads, dams, power-house, bridges,
school buildings, hospital buildings etc. On the other hand, the investment made by the
private investors or entrepreneurs is called private investment. Private investment is
guided by profit motive. Such investment increases as expected rate of profit increases
and vice versa.

Determinants of investment

The main determinants of investment are as follows.

A. Short-run factors: The important short-run factors determining the volume of
investment can be stated as follows.
1. Expected demand: If the demand for goods is expected to rise in future, MEC will be
high. As a result the investment will increase. Reverse will happen when the demand
for goods is expected to fall in future.
2. Nature of cost and prices: If the entrepreneurs expect the prices of goods to rise and
the costs of production to fall in future, MEC will be high and investment will
increase. Reverse will happen when the prices of goods are expected to fall and
costs of production to rise in future.
3. Propensity to consume: Increase in consumption function leads to an increase in the
demand for consumer goods. As a result investment increases because demand for
capital goods is derived from the demand for consumer goods. Reverse will happen
when consumption function decreases.
4. Change in income: The change in income of the community affects the MEC and the
volume of investment by influencing the demand for goods. The increase in income
of the community encourages the investment and decrease in income of the
community discourages the investment.
5. Waves of optimism and pessimism: During the period of business optimism, the rate
of profit on future investment is expected to be high. As a result, investment
increases. On the other hand, during the period of business pessimism, the rate of
profit on future investment is expected to be low. As a result, investment decreases.
6. Taxation policy of the government: Heavy doses of direct and indirect taxes
adversely affect MEC and hence investment decreases. On the other hand, tax
concession and tax rebates tend to raise MEC and hence investment increases.
 7. Current state of expectation: Generally, the entrepreneurs invest on the assumption
that the current state regarding prices, costs etc. will continue even in future. Hence,
if the current rate of return on investment is high, investment on new projects
increases. Reverse will happen if current rate of return on investment is low.
8. Political condition: Political instability in the country lowers the business
expectation. As a result, investment decreases. On the other hand, political stability
in the country creates confidence in business community. As a result, investment
increases.
B. Long-run Factors: Long-run factors determining the volume of investment can be stated
as follows.
1. Population: High rate of population growth increases the demand for consumer
goods and capital goods. This will lead to an increase in MEC and the volume of
investment.
2. Technological progress: Technological advancement stimulates investment activities.
This is so because technological progress leads to the development of new
techniques of production and creation of new markets which have favorable effect
on MEC and investment.
3. Development of new residential areas: Development of new residential areas
requires additional transport and communication facilities, construction of
residential and commercial buildings, additional electricity facility etc. As a result,
investment increases.
4. Utilization of existing capital equipments: If the productive capacity of existing stock
of capital equipments is not utilized fully and it is sufficient to meet the increased
demand, there will be no new investment. On the other hand, if the productive
capacity of existing stock of capital equipments is fully utilized and it is not sufficient
to meet the increased demand, investment will increase.
5. Long-run economic policy of the government: If the government adopts the policy of
socialism and nationalization of industries, MEC will be low and private investment
will decrease. On the other hand, if the government adopts the liberal economic
policy to encourage private investment, MEC will be high and private investment will
increase.

Marginal Efficiency of Capital

Marginal efficiency of capital (MEC) is the rate of return expected from an additional unit of a
capital asset over its cost. In this sense MEC can be defined as the rate of profit expected from
the given investment on a capital asset. In other words, MEC is the percentage of profit
expected from the given investment on a capital asset.
 Keynes relates the prospective yield of the capital asset to its supply price and defines
MEC. The prospective yield of capital asset is the total net return expected from a capital asset
during its life time. Similarly, supply price of capital asset is the cost of producing new capital
asset or the cost incurred on the purchase of new capital asset. According to Keynes, MEC is the
rate of discount which makes the total present value of annual returns expected from the
capital asset during its life time just equal to its supply price. This can be expressed as follows.
𝑅1 𝑅2 𝑅3 𝑅𝑛
SP = + + + ….. +
(1+𝑟)1 (1+𝑟)2 (1+𝑟)3 (1+𝑟)𝑛
Where,
SP represents the supply price of capital asset.
R1, R2, R3, ..... , Rn represent the series of annual returns expected from the
capital asset in different years.
r represents the rate of discount which makes the total present value of the
annual returns expected from the capital asset during its life time equal to its supply price.
Hence, r represents the marginal efficiency of capital.

The concept of MEC can be illustrated with the help of an example as follows.
Suppose that the supply price of a capital asset is Rs. 16,000 and its life span is three
years. The capital asset is expected to yield Rs. 5,500 in the first year, 6,050 in the second year
and 7,986 in the third year. Let us further suppose that the capital asset has no scrap value
after three years. In such a case, MEC will be as follows.
𝑅1 𝑅2 𝑅3
Sp = + +
(1+𝑟)1 (1+𝑟)2 (1+𝑟)3
5,500 6,050 7,986
Or, 16,000 = + +
(1+0.1)1 (1+0.1)2 (1+0.1)3
5,500 6,050 7,986
Or, 16,000 = + +
1.1 1.21 1.331
Or, 16,000 = 5,000 + 5,000 + 6,000
Or, 16,000 = 16,000

In the above example, 10% discount rate makes the total present value of the annual returns
expected from the capital asset during its life time just equal to its supply price. Therefore, in
the above example, MEC is 10%

MEC and Decision Rules

The concept of MEC is very useful in making investment decision. Investment decision can be
made by comparing MEC with the market rate of interest. The investment decision rules can be
stated as follows.
 a. If MEC > market rate of interest, investment will be profitable and the investor decides
to invest on the proposed project.
b. If MEC < market rate of interest, investment will be unprofitable and the investor
decides not to invest on the proposed project.
c. If MEC = market rate of interest, it is the situation of indifference towards the
investment. In such a case, the investor may or may not decide to invest on the
proposed project.

MEC and Investment Curve

Marginal efficiency of capital (MEC) varies inversely with the volume of investment. In other
words, MEC diminishes as the volume of investment increases and vice versa. There are two
reasons for this.
a. When the volume of investment increases, prospective yield of capital asset falls due to
the operation of the law of diminishing returns in production.
b. When the demand for the capital asset increases, its supply price rises due to the
increase in cost of production in capital goods industry.

Thus, MEC falls with the increase in volume of investment and vice versa which makes MEC
curve downward sloping. This has been shown in the following figure.
 In the above figure, MEC curve is downward sloping which indicates that MEC varies
inversely with the volume of investment. Volume of investment depends upon MEC and the
rate of interest. Equilibrium level of investment is determined at the point where MEC
becomes equal to market rate of interest. In the above figure, when the rate of interest is
OR1, equilibrium level of investment is OI1 because at OI1 level of investment, MEC is equal
to the rate of interest. Similarly, at OR2 rate of interest, the equilibrium level of investment
is OI2 because at OI2 level of investment, MEC is equal to the rate of interest. In the same
way, at OR3 rate of interest, equilibrium level of interest is OI3 because at OI3 level of
investment, MEC is equal to the rate of interest. Thus, MEC curve shows the demand for
investment at various rates of interest. Hence, MEC curve represents the investment
demand curve. The investment demand curve slopes downward from left to right which
shows inverse relationship between rate of interest and volume of investment.

Difference Between Marginal Efficiency of Capital (MEC) and

Marginal Efficiency of Investment (MEI)

Conceptual differences between MEC and MEI are as follows.

1. The MEC is based on a given supply price of capital, whereas the MEI is based on
induced changes in supply price of capital.
2. The MEC determines the optimal stock of capital in the economy at each level of
interest rate, whereas the MEI determines the net investment in the economy at each
level of interest rate.
Income Determination in a Two-sector Model

The two –sector model of income determination consists of only the household sector
and business sector. Two-sector model is the most basic Keynesian model of income
determination. This model is based on the following assumptions.
1. There are only two sectors in an economy, i.e., the household sector and business
sector.
2. There is no foreign trade.
3. Since there is no government sector, there is no tax and no government expenditure.
4. There are no corporate undistributed profits.
5. All prices including factor prices remain constant.
6. The supply of capital and the state of technology are given.

Two-sector model of income determination can be explained as follows.

A. AD – AS Approach: In a two-sector economy, equilibrium level of income is determined
at a point where aggregate demand (C + I) equals aggregate supply (C + S). This can be
expressed as follows.
Aggregate demand = Aggregate supply
C+I=C+S
Aggregate demand is the sum of aggregate consumption expenditure (C) and
aggregate investment expenditure (I). Aggregate demand curve slopes upward to the
right indicating a direct relationship between income and aggregate demand.
Aggregate supply refers to the total money value of goods and services
produced in an economy in a year. Aggregate supply curve slopes upward to the right
indicating a direct relationship between income and aggregate supply.
The determination of equilibrium level of income in a two-sector economy has been
illustrated in the following figure.

In the above figure, C+I curve represents the aggregate demand and 45 o line
or Y = C+S curve represents the aggregate supply. These two curves intersect each other
at point E where aggregate demand is equal to aggregate supply. Hence, E is the
equilibrium point and OY is the equilibrium level of income. At any level of income less
than OY, aggregate demand exceeds aggregate supply. This excess demand leads to the
decline in the inventories of goods below the desired levels. In such a case, the firms
expand output to meet the extra demand for goods and services and to keep
inventories of goods at desired levels. As a result, output, employment and income
increase in the economy and continue to increase till equilibrium level of income OY is
reached. On the other hand, at any level of income greater than OY, aggregate supply
exceeds aggregate demand. This leads to the increase in inventories of goods with the
firms beyond the desired levels. In such a case, the firms cut down production to keep
the inventories of goods at the desired levels. As a result, output, employment and
 income in the economy fall and continue to fall till equilibrium level of income OY is
reached. Thus, in the figure, OY is the equilibrium level of national income.
B. Saving-Investment Approach: The equilibrium level of income can also be shown by the
equality of saving and investment. We know that equilibrium level of income is
determined at a point where aggregate supply is equal to aggregate demand which can
be expressed as follows.
C+S=C+I
... S = I
The determination of equilibrium level of income by the equality of saving and
investment has been illustrated in the following figure.

In the above figure, II1 is autonomous investment curve and SS1 is the saving curve. These two
curves intersect each other at point E where saving is equal to investment. Hence, E is the
equilibrium point and OY is the equilibrium level of income.
At any level of income less than OY, investment exceeds saving. This means that at less than OY
level of income, aggregate demand is greater than aggregate supply. This excess demand leads
to the decline in the inventories of goods with the firms below the desired levels. In such a case,
the firms increase output to meet the extra demand for gods and services and to keep
inventories of goods at the desired levels. As a result, output, employment and income in the
economy increase and continue to increase till equilibrium level of income OY is reached. On
the other hand, at any level of income greater than OY, saving exceeds investment. This means
that at more than OY level of income, aggregate supply is greater than aggregate demand. This
leads to the increase in inventories of goods with the firms beyond the desired levels. In such a
case, the firms cut down production to keep the inventories of goods at the desired levels. As a
result, output, employment and income in the economy fall and continue to fall till equilibrium
level of income OY is reached.
 Investment Multiplier

The concept of multiplier occupies an important place in the Keynesian theory of income and
employment. The concept of multiplier was first developed by R.F. Kahn in the form of
employment multiplier. Keynes borrowed the idea from Kahn’s employment multiplier and
formulated the concept of investment multiplier. According to Keynes, investment multiplier
expresses the quantitative relationship between an initial increase in investment and the final
increase in aggregate income. It tells us that when there is an increase in investment, aggregate
income will increase by an amount which is K times the increased investment. This can be
expressed as follows.
ΔY = KΔI
Where,
ΔY = Change in aggregate income.
ΔI = Change in investment.
K = Investment multiplier.
ΔY
... K =
ΔI

Thus, investment multiplier is the ratio of change in aggregate income to the change in
investment. It tells us how many times of the increased investment will the income increase in
the economy when the investment increases. The basic idea behind the concept of investment
multiplier is that when an additional investment is made in the economy, the aggregate income
increases not only by the amount of original investment but by much more than the original
investment. This is so because expenditure of one group becomes income of another group.

Relation between MPC and Investment Multiplier

This size of investment multiplier depends upon the size of MPC. There is direct relationship
between the size of MPC and the size of investment multiplier. This means that higher the MPC,
higher is the investment multiplier and vice versa. Such relationship between MPC and
investment multiplier can be proved mathematically as follows.
Equilibrium condition for two-sector economy can be stated as follows.
Y=C+I
.
. . ΔY = ΔC + ΔI
Or, ΔY = bΔY + ΔI [... ΔC = bΔY]
Or, ΔY – bΔy = ΔI
Or, ΔY (1 – b) = ΔI
 1
Or, ΔY = ΔI
1−b
ΔY 1
Or, =
ΔI 1−b
1 ΔY
Or, K = [... = K and b denotes MPC]
1−MPC ΔI
1 1
Or, K = =
1−MPC MPS

The above expression clearly shows that the size of investment multiplier varies directly with
MPC and inversely with MPS. This can also be illustrated by the following table.
MPC MPS 1
Investment Multiplier [ K = ]
1−MPC
0 1 1
1⁄ 1⁄ 2
2 2
2⁄ 1⁄ 3
3 3
3⁄ 1⁄ 4
4 4
4⁄ 1⁄ 5
5 5
5⁄ 1⁄ 6
6 6
6⁄ 1⁄ 7
7 7
7⁄ 1⁄ 8
8 8
8⁄ 1⁄ 9
9 9
9⁄ 1⁄ 10
10 10
1 0 ∞

The above table shows that the size of investment multiplier varies directly with the MPC and
inversely with the MPS. According to psychological law of consumption, the value of MPC is
greater than zero but less than one (i.e., 0<MPC<1). Hence, the size of investment multiplier lies
between one and infinity.

Change in Aggregate Demand and Investment Multiplier

Change in investment leads to the change in aggregate demand in the economy. When
aggregate demand changes due to the change in investment, this will lead to the change in
equilibrium level of national income. In such a case, investment multiplier determines the
magnitude of the change in equilibrium level of national income in response to the change in
investment. For example, if the value of investment multiplier (K) = 2, this implies that when
investment increases, equilibrium level of national income increases by two times the increased
investment. This has been illustrated in the following figure.

In the above figure, consumption curve C has been drawn on the assumption that MPC is 0.5. In
such a case, the size of multiplier will be equal to 2. Initially, the economy is in equilibrium at
point E1 where aggregate demand (C + I) is equal to aggregate supply (C + S). At this equilibrium
point, OY1 equilibrium level of income is determined. When investment increases by ΔI,
aggregate demand curve C+I shifts upward and becomes C+I+ ΔI. New aggregate demand curve
C+I+ ΔI intersects aggregate supply curve Y = C+S at point E2. Hence, E2 is the new equilibrium
point of the economy. At this point, new equilibrium level of income OY 2 is determined. In the
present case, the size of multiplier is 2. Hence, in the figure ΔY (i.e., Y 1Y2) is equal to two times
the increased investment of ΔI (i.e., ΔY = 2 ΔI).

Process of Income Propagation through Investment Multiplier

Suppose that the MPC is 0.5 in an economy. In such a case, the size of investment multiplier will
be as follows.

1
K = 1−MPC

1
=
1−0.5

1
= =2
0.5
Let us further suppose that investment is increased by Rs. 100 crore in the economy. Under the
given conditions, the income increases in the economy by two times the increased investment
of Rs. 100 crore. This can be expressed as follows.
∆Y
K=
∆I

Or, ΔY = KΔI

Or, ΔY = 2 x 100

Or, ΔY = Rs. 200 crore (i.e., two times the increased investment of Rs. 100 crore)

The whole process of income propagation through investment multiplier can be illustrated with
the help of the following table.
Period ΔI ΔY ΔC ΔS (ΔY – ΔC)

(Increment in (Increment in (Increment in (increment in

Investment) Income) Consumption) saving)
MPC = 0.5
1 100 100 50 50

2 50 25 25

3 25 12.5 12.5

4 12.5 6.25 6.25

… … … …

… … … …

N 0 0 0

Total 100 200 100 100

The above table is based on the assumption that in an economy, MPC is 0.5 and investment is
increased by Rs. 100 crore. Since MPC is 0.5, the size of investment multiplier (K) will be equal
to 2. The table shows that when the investment increases by Rs. 100 crore in the economy, the
income also increases by the same amount (i.e., by Rs. 100 crore) in the first period. Out of the
increased income of Rs. 100 crore, Rs. 50 crore is spent on consumption and Rs. 50 crore is
saved. The consumption expenditure of Rs. 50 crore leads to an increase in income by the same
amount (i.e., by Rs. 50 crore) in the second period. Out of the increased income of Rs. 50 crore,
Rs. 25 crore is spent on consumption and Rs. 25 crore is saved. The consumption expenditure of
Rs. 25 crore leads to an increase in income by the same amount (i.e., by Rs. 25 crore) in the
third period and so on. This process will continue till the income increases by Rs. 200 crore in
the economy. Since K = 2 in the present case, income has increased by two times the increased
investment of Rs. 100 crore, i.e., ΔY = 2ΔI = 2 x 100 = Rs. 200 crore.
 Leakages of Multiplier
When whole of the increased income is not spent on consumption, a part of it leaks out
of the income stream. This lowers the size of multiplier and checks the multiplier process. This
is called leakage of multiplier. Some important leakages of multiplier can be stated as follows.
1. Hoarding: If the people have a tendency to hoard the increased income in the form of
idle cash balances, they will reduce consumption expenditure. This will lead to leakage
of multiplier and the process of income propagation will be slowed down.
2. Inflation: When there is a rise in the prices of consumer goods, a part of the increased
income is absorbed by higher prices and the real income and consumption fall. This will
lead to leakage of multiplier and the process of income propagation will be slowed
down.
3. Imports: If there is an excess of imports over exports, a part of the increased domestic
income will leak out of the domestic income stream. This will lead to leakage of
multiplier and the process of income propagation will be slowed down.
4. Saving: Since MPC is less than one, the whole of the increased income is not spent on
consumption. A part of it is saved which leaks out of the income stream. This will
weaken the multiplier process by lowering the size of multiplier. Hence, saving is the
leakage of multiplier. Higher the MPS, greater is the leakage of multiplier.
5. Purchase of old stock and securities: If the people purchase old stock and securities
with their increased income, this type of financial investment reduces consumption
expenditure and lowers the size of multiplier. This means leakage of multiplier.
6. Taxation: When the government imposes taxes on the income and property of the
people, it reduces the disposable income of the people and consumption expenditure
falls. Similarly, if the government imposes commodity taxes, this leads to a rise in prices
of goods and a part of increased income is absorbed by higher prices. This leads to a fall
in real income and consumption. All these factors weaken the multiplier process by
lowering the size of multiplier.
7. Undistributed profit: When a part of the profits of business corporations is not
distributed to the shareholders in the form of dividends and is kept in reserve fund, this
reduces the income of the shareholders and their consumption expenditure. This
weakens the multiplier process by lowering the size of multiplier.
8. Debt cancellation: When a part of increased income is used to repay the debts then that
part of income leaks out of the income stream. This weakens the multiplier process by
lowering the size of multiplier.

Uses/Importance of Multiplier
Uses or importance of multiplier can be explained as follows.
1. Importance of investment: The concept of multiplier tells us that when the investment
increases, the income increases by an amount which is multiplier times the increased
 investment. Hence, the concept of multiplier highlights the importance of investment in
the process of income generation in the economy.
2. Deficit financing: The concept of multiplier highlights the importance of deficit
financing. During depression, even the cheap money policy fails to encourage the
private investment because marginal efficiency of capital (MEC) is very low during
depression. In such a situation, increase in public expenditure by way of deficit budget
helps in increasing income and employment through multiplier process.
3. To solve the problem of unemployment: The concept of multiplier clearly indicates that
an initial increase in investment leads to the increase in income and employment
through multiplier process. Hence, the volume of investment should be increased to
remove unemployment.
4. Saving-investment equality: The concept of multiplier helps to understand how the
equality between saving and investment is brought about. An increase in investment
leads to the increase in income through multiplier process. As a result of increase in
income, saving also increases and becomes equal to investment.
5. To control trade cycle: The concept of multiplier helps to understand the causes of
different phases of trade cycle and to control them. For example, when investment falls,
income and employment also fall in a cumulative manner which leads to economic
recession and ultimately to economic depression. Similarly, when investment increases,
income and employment also increase in a cumulative manner which leads to economic
revival and ultimately to boom. Hence, the concept of multiplier helps to understand
and control the different phases of trade cycle.
6. Economic policy: Multiplier is a useful tool in the hands of policy-makers in formulating
suitable economic policies for the solution to the problem of unemployment and
business fluctuations.